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Rediff.com  » Business » Why US must revamp financial regulation

Why US must revamp financial regulation

By BS Bureau
April 23, 2010 12:38 IST
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Any assessment of Goldman Sachs' alleged "fraud" is likely to run into two problems. First, the armada of jargon that surrounds the financial derivatives market could mean that the essence of the case is lost in translation, leaving the non-specialist bewildered as to the exact nature of the Wall Street giant's alleged perfidy.

Second, given the firm's role in the financial crisis and its patently insensitive decision to hand out obscenely large bonuses to its employees at the peak of the US recession, it would be difficult to find too many hearts that bleed for Goldman Sachs. This is likely to bias judgment. However, an objective assessment is likely to show that US securities market regulator SEC's case against Goldman Sachs is far from being open and shut.

The key elements of the case are as follows. Goldman Sachs created a complex instrument called a synthetic collateralised debt obligation (CDO) and christened Abacus that enabled a key client, Paulson and Company, to bet against the US mortgage market. Shorn of all the complexities, a CDO is a portfolio of securities - in this case securities backed by residential mortgages.

Mr Paulson betted against the mortgage market by shorting these securities, that is selling them in the future at a fixed price. If their actual market prices declined below this fixed price, which they did, Paulson would stand to gain, which he did. As the US sub-prime collapsed in 2007, Mr Paulson netted a cool billion dollars.

Every seller needs a buyer and Paulson would not be able to "short" the CDO if Goldman Sachs had not been able to fund a buyer. The key buyers in this case were a German Bank, IKB and American firm ACA Management.

The core of the SEC allegation is that Goldman Sachs marketed the CDO to these firms without informing them that Mr Paulson was running a huge short on the very CDO that they had decided to buy or go long on. But that is hardly the cardinal offence that the SEC is making it out to be.

For one, both the buyers and sellers were specialist investors who presumably took informed calls on the mortgage market. It's not as if Goldman was pitting the interests of some retail investors against a Wall Street Goliath.

All that Goldman did as a financial intermediary was to devise an instrument by which IKB and Paulson's calls could translate into actual trades. Should it have disclosed Mr Paulson's identity and trading position to IKB and ACA?

Market-making is often done on the basis of anonymity and one could argue that Goldman really had no obligation to tell Abacus' buyers about who was on the other side of the trade. There are other allegations that also can be viewed in more than one way. So what's the fuss all about?

This is not to exonerate Goldman or for that matter any of the major Wall Street Banks of their role in fostering a culture of greed, over-borrowing and reckless risk-taking that ultimately precipitated the financial meltdown.

Financial regulation in the US needs overhaul and it is surprising that almost three years after the crisis broke, no serious regulatory change has taken place.

The fact that the SEC produced this somewhat flimsy charge against Goldman is perhaps evidence of the US administration's growing desperation to make a case for regulatory reform in a policy environment that, courtesy the lobbying power of banks, is still heavily biased in Wall Street's favour.

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BS Bureau
Source: source
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